This invention relates to the field of risk analysis and, in particular, to derecognition of debt.
In order to establish uniformity in financial statement presentation the American Institute of Certified Public Accountants (AICPA) has published many writings. These writings are collectively referred to as Generally Accepted Accounting Principals (GAAP). GAAP establishes how, where, when and how much is reported on a financial statement. GAAP is required to be used by most businesses but not all. There are some exceptions.
According to GAAP, liabilities must be recorded at their face value. Current liabilities are defined as those that should be paid in one year""s time or less from the Balance Sheet date. Long-term obligations are defined as those that are due to be paid after one year from the balance sheet date. For example, an account payable due in thirty (30) days for $100 would be recorded as a current liability of $100. In the case of a note payable due in ten (10) years the debt would be recorded as a long-term debt.
Whether a debt is an account payable or a note, it is thus recorded at its face value. No consideration is made of the present value of a future obligation when recording the debt. In fact GAAP forbids the recordation of a liability for any amount other than its face amount. However it is well known that long-term liabilities have a present value less than the face value at which they are recorded. Thus, the recorded value is greater than the actual present value but most companies must carry the greater value on their books in order to comply with GAAP.
Therefore, in order to avoid this inequity in GAAP some companies might find it desirable to sell one or more of its long-term obligations for a sum that approximates the present value of this debt. In order to accomplish this objective the debtor must derecognize this liability. According to GAAP in order for a liability to be extinguished one of the following conditions must be met:
The debtor pays the creditor and is relieved of its obligation for the liability. Or, the debtor is legally released from being the primary obliger under the liability, either judicially or by the creditor.
Liabilities are defined by GAAP as xe2x80x9cprobable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.xe2x80x9d Items that would otherwise be classified as a liability would not be recognized as a liability if insured under a contract of insurance with a recognized insurance carrier. An example would be a company that is self insured for worker""s compensation. The company""s future loss obligations would be reflected as a liability on its financial statement according to GAAP. If the company were to then purchase a workers"" compensation insurance contract, the liability would be derecognized in exchange for the premium paid to the insurance carrier.
The purchaser of the debt would therefore have to be an insurance carrier. The purchaser of the debt must be able to make a profit otherwise there is no business purpose for them to enter into the transaction. The insurance company would therefore charge a premium in excess of the present value of the obligation. The total sum paid by the seller would still be less than the face amount. Both buyer and seller profit.
A method for reducing risk including the steps of holding by a seller a liability having a future value S1 and determining the present value P1 of the liability in accordance with the future value S1. The method also calls for buying the liability by a buyer entity for a value P2 greater than the present value P1, thereby providing a first net gain holding the liability by the buyer entity for a period of time and discharging the liability at the end of the period of time for a value S1 that is less than the value S2 thereby providing a second net gain. The present value P2 is determined according to the present value P1 and according to a time t years prior to the time at which the value of the liability reaches S1. The present value P2 is determined according to the value S2 and the future value S1 is known at the time of the determining of the present value P1. The first net gain is a net gain for the seller and the second net gain is a net gain for the buyer entity. The buyer entity can be an insurance company.